Strategic Management Journal

Strat. Mgmt. J., 27: 1183–1204 (2006)

Published online in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/smj.567

INTERNET COMPANIES’ GROWTH STRATEGIES:

DETERMINANTS OF INVESTMENT INTENSITY AND
LONG-TERM PERFORMANCE
THOMAS R. EISENMANN*
Harvard Graduate School of Business Administration, Boston, Massachusetts, U.S.A.

To exploit first-mover advantages, pioneers may be motivated to amass customers before rivals
enter the market. Likewise, when they enjoy increasing returns due to network effects, static
scale economies, or learning effects, companies have incentives to invest aggressively in growth.
This paper presents econometric analysis of factors that determined the intensity of Internet
companies’ investments in growth, and analyzes the long-term performance consequences of
such investments. Results indicate that first movers spent significantly more on upfront marketing
than non-pioneers. Contrary to expectations, however, firms in markets that exhibited increasing
returns did not spend more on their early customer acquisition efforts than other sample
companies. Although the typical sample company did not earn positive long-term returns,
heavy early investments in growth were nevertheless economically rational. In most cases,
reducing marketing outlays would have worsened a bad outcome, consistent with an inverted ‘U’
relationship between long-term returns and upfront marketing spending. Thus, the typical sample
company invested in marketing, ex ante, at levels close to those that would have maximized
returns, observed ex post. Copyright  2006 John Wiley & Sons, Ltd.

In new markets, firms often seek to accelerate
their growth. The motivation to amass customers
is especially strong in industries that exhibit high
customer switching costs (Klemperer, 1987; Wer-
nerfelt, 1991). Likewise, firms have an incentive
to increase customer acquisition efforts when they
enjoy increasing returns to scale due to network
effects (Katz and Shapiro, 1985, 1986), static scale
economies based on high fixed costs, or dynamic
learning effects (Spence, 1981). With increas-
ing returns, winner-take-all (WTA) outcomes may
prevail, and first movers may gain advantage
by acquiring customers before competitors enter
the market. Absent entry barriers, however, the
Keywords: accelerated growth strategies; first-mover
advantage; network effects
*Correspondence to: Thomas R. Eisenmann, Harvard Graduate
School of Business Administration, Rock Center 218, Boston,
MA 02163, U.S.A. E-mail: teisenmann@hbs.edu
first mover in a WTA market may quickly face
rivals, and fierce competition to acquire customers
may dissipate rents (Fudenberg and Tirole, 1987;
Lieberman, 1987).
Rent dissipation may explain the mixed track
record of companies that have tried to accelerate
customer growth. During the 1970s, many man-
ufacturing firms experienced ruinous results after
they embraced ‘experience curve’ strategies (Day
and Montgomery, 1983; Lieberman, 1987). More
recently, Internet companies spent heavily to accel-
erate growth. Managers perceived a ‘land grab’
opportunity, and often believed their businesses
would enjoy increasing returns. For the 117 Inter-
net companies that comprise this paper’s sam-
ple, marketing spending equaled 46 percent of
total capital raised from their inception through
2001. After the Internet valuation bubble burst,
conventional wisdom held that this spending was

Copyright  2006 John Wiley & Sons, Ltd.

1184 T. R. Eisenmann
wasteful (e.g., Madrick, 2001; Lewis, 2002). The
typical sample company did fare badly: by year-
end 2001, 16 percent were bankrupt, and another
57 percent had a market value less than the total
amount of capital they had raised. Of course, an
association between heavy marketing spending and
poor median returns does not demonstrate causal-
ity. After all, 27 percent of the sample companies
yielded a positive return to investors, and results
were spectacular for a few firms.
This research evaluates factors that encour-
aged accelerated growth strategies and examines
the long-term performance consequences of such
strategies. Accelerated growth strategies are de-
fined here as efforts to acquire customers rapidly
in new markets through heavy marketing spend-
ing, discounting aggressively, or absorbing rivals
through mergers. Growth is ‘accelerated’ to the
extent that a firm sacrifices current profits—those
that would result from ‘myopic’ decisions about
pricing, marketing expenditures, or mergers—in
order to maximize the present value of future prof-
its (Rao and Bass, 1985; Makadok, 1997). How-
ever, our focus is not on marketing mix optimiza-
tion; rather, we explore circumstances under which
the appropriate answer to one of strategy’s fun-
damental questions—‘How to compete?’—is, to
borrow Amazon.com’s mantra, ‘Get big fast!’ In
new markets subject to increasing returns due to
strong network effects, a firm can achieve differ-
entiation by amassing more customers than rivals.
Likewise, with increasing returns due either to
static or dynamic supply-side scale economies, a
firm can achieve cost advantage by acquiring cus-
tomers faster than rivals. With increasing returns,
WTA dynamics may prevail. In that event, accel-
erated growth becomes a strategic imperative, and
decisions regarding accelerated growth can have
‘bet-the-company’ consequences.
To date, few empirical studies have explored
factors that encourage the pursuit of accelerated
growth strategies and the pay-off from such strate-
gies. Early empirical research on the relation-
ship between marketing spending and profitability
focused on mature, stable industries rather than
new markets (e.g., Comanor and Wilson, 1974;
Biggadike, 1979). Growth strategies in new mar-
kets are viewed as being conceptually distinct from
efforts to gain share in mature markets (Spence,
1979; Aaker and Day, 1986). In new markets, first-
mover advantages are more salient, and companies
Copyright  2006 John Wiley & Sons, Ltd.
may face greater uncertainty about investment pay-
offs.
Research on first-mover advantage has, by def-
inition, examined new markets, but such research
has typically focused on the impact of entry
order on market share (Kalyanaram, Robinson, and
Urban, 1995), rather than factors that encourage
firms to pursue aggressive customer acquisition
efforts. Other empirical studies have investigated
such factors, but these studies have not assessed
the long-term impact of accelerated growth strate-
gies on profitability or valuation (Rao and Bass,
1985; Gatignon, Weitz, and Bansal, 1990; Maka-
dok, 1997; Noble and Gruca, 1999).
Likewise, few empirical studies have explored
strategies for exploiting increasing returns. Most
empirical work on network effects, for exam-
ple, has focused on technology adoption deci-
sions (e.g., Saloner and Shepherd, 1995; Majumdar
and Venkataraman, 1998; Schilling, 2002). Only
a few studies have examined strategies used to
amass customers in markets with network effects,
or how network effects influence financial per-
formance (e.g., Garud and Kumaraswamy, 1993;
Ohashi, 2003; Rysman, 2004; Shankar and Bayus,
2003). Consistent with results reported in this
paper, Lieberman (2002) found that first movers
in the Internet sector were more likely to real-
ize superior market valuations when their busi-
ness models leveraged network effects. This paper
complements Lieberman’s by testing whether these
performance advantages were contingent on firms’
decisions to invest in growth strategies.
The rest of the paper is organized in four
sections. The first reviews relevant research and
presents hypotheses. The second describes sample
selection criteria and econometric methods. The
third presents results. The final section analyzes the
results, discusses their generalizability, and consid-
ers implications for future research.
REVIEW OF RESEARCH AND
HYPOTHESES
This section reviews past research on two issues.
First, in new markets, what factors determine the
intensity of firms’ upfront investments in growth?
Second, when firms pursue accelerated growth
strategies, do they tend to invest, ex ante, at levels
that maximize long-term returns, observed ex post?
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies
Determinants of investment intensity
First-mover status
Past research yields conflicting predictions regard-
ing the impact of first-mover status on firms’
propensity to invest in growth. First movers might
benefit from aggressive marketing efforts in two
ways. First, to the extent that they enjoy network
effects, proprietary learning effects, and/or switch-
ing costs, first movers may profit by preemptively
acquiring customers (Lieberman and Montgomery,
1988). This possibility is explored below. Second,
pioneers may have cost advantages in acquiring
customers, both before and after rivals enter. If
rivalry will bid up the price of scarce promo-
tional channels, pioneers may have an incentive
to acquire customers before competition ensues.
Pioneers may secure sustainable acquisition cost
advantages if they can preemptively sign long-
term, low-priced contracts with promotional part-
ners. Also, if pioneers can build brand equity
before rivals enter, they subsequently may spend
less to convert a prospect, compared to entrants.
Despite these potential benefits, first movers
may prefer to avoid accelerated growth strate-
gies for three reasons. First, pioneers are more
likely than later entrants to change their business
models, because pioneers face greater uncertainty
about customer needs and a greater risk of adopt-
ing technologies later rendered obsolete (Schnaars,
1994). When companies reposition their products,
they may confuse prospects and alienate existing
customers, eroding the value of earlier marketing
investments. Second, notwithstanding the poten-
tial acquisition cost advantages cited above, with a
fundamentally new product or service, heavy mar-
keting investments may be required to build aware-
ness. Some prospects might require evidence about
product performance that only accrues through the
sheer passage of time. With these prospects, boost-
ing early advertising or promotional outlays is
unlikely to be effective.
Once they face rivals, first movers are less
likely to pursue accelerated growth strategies if
they have strong incentives to cede share. An
extensive body of theoretical work in industrial
organization economics (see Fudenberg and Tirole,
1986, for a review) and marketing (e.g., Hauser
and Shugan, 1983; Gruca, Kumar, and Sudharshan,
1992) explores conditions under which incumbents
may accommodate new rivals instead of seeking
to deter entry. For example, Farrell and Shapiro
Copyright  2006 John Wiley & Sons, Ltd.
1185
(1988; see Sharpe, 1997, for relevant empirical
results) show that with high customer switching
costs incumbents are more likely to behave like
‘fat cats,’ avoiding price cuts and ceding share to
entrants.
Empirical research on whether incumbents in
growing markets adjust their marketing plans in
response to entry has yielded mixed results. Robin-
son (1988) observed an aggressive reaction. By
contrast, Cubbin and Domberger (1988) found that
incumbents accommodated entrants, and Makadok
(1998) observed that among mutual funds—which
enjoy high switching costs—early movers were
more likely to sustain price premiums than market
share advantages. Shankar (1997) tested a model
that shows when firms should favor an aggressive
versus accommodative reaction.
Although research suggests that late-mover ad-
vantages may, under certain circumstances, offset
first-mover effects, we nevertheless advance the
following hypothesis:
Hypothesis 1: First-mover status encourages
heavy, preemptive investment in customer acqui-
sition efforts.
Winner-take-all markets
Companies have an incentive to pursue accelerated
growth strategies when they can exploit increas-
ing returns to scale. Firms may enjoy demand-
related increasing returns when they control prop-
erty rights required to deliver goods or services that
are subject to network effects (Katz and Shapiro,
1986). Supply-related increasing returns may fol-
low from either static scale economies or, when
learning remains proprietary, from dynamic learn-
ing effects (Ghemawat and Spence, 1985; Lieber-
man, 1987).
Increasing returns are reinforced in the pres-
ence of customer switching costs. Switching costs
include relationship-specific investments and in-
conveniences incurred when a customer changes
from one ex ante homogeneous supplier to another.
To steal a rival’s customers, a company must
compensate the customers for these costs. Con-
sequently, in an otherwise competitive market, a
company should earn a profit at least equal to the
sum of the switching costs confronting its exist-
ing customers (Klemperer, 1987). For this rea-
son, switching costs encourage accelerated growth
strategies, as observed in Makadok’s (1997) study
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
1186 T. R. Eisenmann
of mutual fund pricing. However, in markets with
high switching costs the competition to acquire
first-time customers—those not yet affiliated with
any vendor—may be intense. Upfront rivalry may
dissipate the rents available from customers once
they are locked in (Klemperer, 1987).
Increasing returns to scale may engender ‘win-
ner-take-all’ outcomes, that is, markets with a
sole survivor. However, true monopolies are rare
(Scherer and Ross, 1990: 82). More typically,
niche competitors can survive by focusing on cus-
tomer segments with differentiated needs (Lie-
bowitz and Margolis, 2001: Ch. 5). Hence, in this
research the phrase ‘winner-take-all’ is applied
to markets with high concentration levels. To
paraphrase Frank and Cook (1995), references
here to ‘winner-take-all’ should be read to mean,
‘winners-take-most.’
Participants in WTA markets—both leaders and
laggards—are likely to pursue accelerated growth
strategies. With increasing returns, companies must
consider the intertemporal consequences of pricing
and investment decisions. Beyond marginal rev-
enue and cost in the current period, producing an
incremental unit yields ongoing benefits when cus-
tomers’ willingness to pay increases with network
size or when costs decline with cumulative out-
put. Optimization yields margins below those that
myopically equate current period revenue and cost
for the marginal customer. Specifically, compa-
nies should be willing to reduce price or increase
investment (for example, in marketing or capacity)
up to the point where the current period mar-
gin reduction equals the discounted value of the
ongoing benefit from incremental volume (Spence,
1981; Lieberman, 1987). This suggests:
Hypothesis 2: Participation in winner-take-all
markets encourages heavy, preemptive invest-
ment in customer acquisition efforts.
First movers in WTA markets
Lieberman (1987) presented a model showing that
pioneers who enjoy a long head start over rivals
along with strong proprietary learning effects may
gain an insurmountable cost advantage and earn
high profits by preemptively acquiring customers.
Absent entry barriers, however, rivals may enter
the market shortly after the pioneer. In that event,
Lieberman concludes, intense rivalry is likely to
reduce industry profitability. Extending this logic
Copyright  2006 John Wiley & Sons, Ltd.
to encompass other structural attributes that engen-
der increasing returns, we advance:
Hypothesis 3: First-mover status in winner-
take-all markets encourages heavy, preemptive
investment in customer acquisition efforts.
Long-term performance consequences
Firms face a function that relates their long-term
pay-off—the present value of future cash flows
earned from new customers acquired in the cur-
rent period—to their current period investment in
customer acquisition efforts. Due to diminishing
returns from such efforts, the function typically
will have an inverted ‘U’ shape (Blattberg and
Deighton, 1996). If managers were perfect agents
with perfect information, we would expect them
to invest at value-maximizing levels—i.e., at the
peak of the inverted ‘U.’ However, managers can-
not directly observe the function described above;
they must estimate its shape. With limited data
available in new markets, estimates are likely to
be imprecise, and behavioral biases may lead man-
agers to overestimate pay-offs. Individuals sys-
tematically underestimate risk when they perceive
themselves to be in control of a situation (Langer,
1975) and when they are emotionally invested
in the outcome (Babad, 1987). This may explain
entrepreneurs’ overconfidence regarding their ven-
ture’s odds for success (Cooper, Woo, and Dunkel-
berg, 1988). If they rely on biased estimates, man-
agers will tend to overinvest, relative to value-
maximizing levels observed ex post (Camerer,
1997). Of course, given the information available
ex ante, managers would believe—ex ante —that
they were spending at optimal rates.
Even if they had perfect information and could
avoid behavioral biases, managers would not nec-
essarily behave like perfect agents. Internal control
and compensation systems may motivate managers
to invest in accelerated growth at levels that pro-
mote their personal priorities, rather than share-
holders’ preferences. Agency problems may lead
to over- or underinvestment. For example, control
systems may fail to prevent reckless spending by
managers eager to run a larger company. Alterna-
tively, the bottom-up budgeting processes used in
most large, multidivisional corporations may lead
to excessively conservative behavior (Eisenmann
and Bower, 2000).
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies
Finally, even perfect agents who avoid behav-
ioral biases may not always invest at what they
believe are optimal levels. During a speculative
valuation bubble, if naı̈ve new investors are willing
to assign excessive valuations to firms with strong
revenue growth, a firm’s managers might choose to
invest aggressively in customer acquisition, seek-
ing to drive up their company’s stock price over the
near term. Even if managers believe that long-term
pay-offs might be poor, such investments would
be consistent with the preferences of most princi-
pals, including both naı̈ve new investors and savvy
existing investors who share management’s view
and plan to liquidate their overvalued holdings.
Conversely, perfect agents who avoid behavioral
biases may face constrains that limit their ability to
invest in accelerated growth at levels they believe
would maximize shareholder returns. Firms that
are reliant on external capital markets may peri-
odically face funding constraints (Myers, 1977;
Spence, 1979). Other companies may confront a
threat of antitrust action that precludes mergers that
could profitably boost their scale.
Recognizing that managers may, under cer-
tain circumstances, stray from norms of long-term
profit maximization, we nevertheless advance:
Hypothesis 4: Ex ante, firms in new markets tend
to invest in customer acquisition efforts at levels
that maximize long-term returns, observed ex
post.
DATA AND METHODOLOGY
Sample
The Internet sector’s rapid emergence offers a nat-
ural experiment: the opportunity to study firms’
growth strategies in many new markets (Lieber-
man, 2002). The sector also offers substantial
spread on variables of interest in this study. Inter-
net companies varied widely in their long-term
returns to investors, their marketing spending as
a percentage of revenue, and the extent to which
they enjoyed structural attributes that may engen-
der winner-take-all competition.
The sample of 117 firms, presented in Table 1,
was assembled by screening several lists of Inter-
net companies, including Datastream’s Internet
Index, WSRN.com’s Internet Stock List, Pruden-
tial Volpe’s Internet Taxonomy, and Morgan Stan-
ley’s May 2000 Internet IPO Report. These lists
Copyright  2006 John Wiley & Sons, Ltd.
1187
included 880 unique publicly traded firms. Study-
ing publicly traded firms facilitated the collection
of financial and valuation data. Having completed
an IPO, these companies were—at least at one
time—viewed as having strong prospects. Infer-
ences from this study should be interpreted accord-
ingly: results might differ for the full population of
Internet companies.
Based on a review of SEC filings and company
websites, 686 were excluded from the sample
because they did not employ one of eight generic
business models (Amit and Zott, 2001) that
correspond to Eisenmann’s (2002) taxonomy: In-
ternet service provider (ISP), portal, content pro-
vider, retailer, broker, market maker, networked
utility, and application service provider (ASP).
More than half of the 686 excluded firms pro-
vided hardware or software used to operate web-
sites; most others were telecommunications carri-
ers or professional service firms. Of the 194 com-
panies that met the business model screen, 77 were
excluded based on the following criteria.
U.S.-based customers
Nineteen companies that otherwise met the sample
selection criteria operated principally outside the
United States. It was often difficult to determine
whether these companies were first movers in their
local markets, so they were excluded from the
sample.
Pure play
The performance standard used below—the ratio
of market value to capital raised—can only be
measured at the firm level, whereas first-mover sta-
tus applies at the level of individual product mar-
kets. These constraints dictate a sample of ‘pure
play’ companies. Following Rumelt’s taxonomy
(1974), the sample is comprised of focused firms
that earned at least 70 percent of revenue from a
single market. Six diversified holding companies
(e.g., CMGI) and vertically integrated firms (e.g.,
Excite@Home) that otherwise met the selection
criteria were excluded.
Internet as principal channel
The Internet serves as the sample companies’ prin-
cipal sales channel (Park, Mezias, and Song, 2004).
Multi-channel marketers do not report how their
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
1188 T. R. Eisenmann

Table 1. Sample companies’ business models and competitive sets

Company Business Model/Competitive Set Company Business Model/Competitive Set

ISP RETAILER
Earthlink Paid ISP Bluefly Apparel
Internet America Paid ISP NetBank Banking
Prodigy Paid ISP Amazon Books
DSL.Net DSL Provider Barnesandnoble.com Books
Juno Free ISP NextCard Credit Cards
Netzero Free ISP Register.com Domain Registration
PeoplePC Free ISP Audible E-books
Garden.com Gardening
PORTAL Buy.com General Merchandise
Talk City Community ValueAmerica General Merchandise
Theglobe Community E-greetings Greeting Cards
Ask Jeeves General Interest Peapod Groceries
GoTo.com General Interest Streamline Groceries
Looksmart General Interest Webvan Groceries
NBCi General Interest YouBet.com Horse Wagering
Yahoo General Interest Ashford Luxury Goods
MusicMaker Music CDs
CONTENT PROVIDER Drugstore Online Pharmacy
Crosswalk Christian PlanetRx Online Pharmacy
Hoovers Corporate Data Beyond.com PC Software/Hardware
OneSource Corporate Data Cyberian Outpost PC Software/Hardware
Multex Equity research Onsale PC Software/Hardware
Marketwatch Stock Market News Pets.com Pet Supplies
TheStreet.com Stock Market News FogDog Sporting Goods
Edgar Online Financial Statements Global Sport Sporting Goods
UpRoar Games E-Stamps Stamps
Dr. Koop Health Information Stamps.com Stamps
Healthgate Health Information Alloy Teen Fashion
Forrester Internet Market Research Varsity Textbooks
Net Ratings Internet Traffic Data Etoys Toys
Emusic Music Download BigStar Entertainment Videotapes/DVDs
MP3.com Music Download Health Central Vitamins
ArtistDirect Music News/Information MotherNature Vitamins
Launch Music News/Information Vitmain Shoppe.com Vitamins
Audiohighway Audio Download/Streaming
NetRadio Audio Download/Streaming BROKER
Salon News Magazine FashionMall Apparel Retail Referral
US Search White Pages FreeMarkets B2B RFQ Auctions
Lifeminders Inspirational Autobytel Car Buying
Newsedge Custom Research Autoweb Car Buying
Quokka Sports Ftd.com Flowers
Sportsline Sports ImproveNet Home Improvement Services
INT Media Group Internet News Insweb Insurance Brokerage
CNET Technology News/Reviews Quotesmith Insurance Brokerage
Iturf Teen Eloan Mortgage Brokerage
Snowball Teen Mortgage.com Mortgage Brokerage
Ivillage Womens CoolSavings Incentive Programs
Women.com Womens MyPoints Incentive Programs
ValueClick Incentive Programs
MARKET MAKER HomeStore Real Estate Brokerage
24/7 Media Ad Networks Be Free Online Affiliate Networks
Doubleclick Ad Networks Ameritrade Securities Brokerage
Engage Ad Networks E-Trade Securities Brokerage
Iprint Digital Printing Services WebStreet Securities Brokerage
Healtheon WebMD Health Industry Transactions Expedia Travel agency
SciQuest Lab Chemicals Travelocity Travel agency
Ventro Lab Chemicals Knot Wedding goods/services
Ebay Person-to-Person Auctions
FairMarket Person-to-Person Auctions ASP
Dice, Inc. Recruitment Critical Path Email
Headhunter.net Recruitment Corio Enterprise Applications
Hotjobs Recruitment USInternetnetworking Enterprise Applications
Priceline Surplus Travel Inventory
NETWORKED UTILITY
Tumbleweed Secure Document Delivery
RealNetworks Streaming Media

Bold type denotes first mover within competitive set.

Copyright  2006 John Wiley & Sons, Ltd. Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies
marketing budgets are allocated across channels,
so it is impossible to measure their online mar-
keting expenditures. Consequently, 12 companies
that otherwise met the selection criteria but relied
on offline channels (e.g., printed catalogs, ‘brick
and mortar’ stores) for more that 50 percent of
2001 revenue were excluded. Some multi-channel
marketers elected to spin off their online units as
separate public companies, and thus do not present
data availability problems. Seven such companies
were included in the sample (e.g., Barnesandno-
ble.com, Vitaminshoppe.com).
Marketing expenditures reported
Twelve companies which otherwise met the selec-
tion criteria aggregated marketing expenditures
into selling, general and administrative expenses,
and were omitted from the sample.
Pre-2001 mergers excluded
The sample includes going concerns, firms that
failed, and firms that merged during 2001. Twenty-
eight companies that otherwise met the selec-
tion criteria completed mergers prior to 2001.
These companies were excluded from the sam-
ple, because their merger transaction values were
inflated by the Internet stock bubble and were not
deemed comparable to the 2001 valuation data
used for other sample companies.
Analytical approach
A two-step analytical approach was employed.
In step one, testing Hypotheses 1, 2, and 3, we
explored whether first-mover status and participa-
tion in WTA markets influenced the intensity of
firms’ investments in accelerated growth. IPO-year
marketing spending was used to measure accel-
erated growth strategies. Reliable measures could
not be developed for two other tactics firms use
to accelerate their growth: aggressive discounting
and mergers. It often was impossible to observe the
pricing of business-to-business transactions. Like-
wise, it was sometimes difficult to discern whether
mergers were motivated by customer acquisition
goals or by other opportunities, such as acquiring
talent or technology.
Using IPO-year data provided a common refer-
ence point for comparing the sample companies’
Copyright  2006 John Wiley & Sons, Ltd.
1189
growth strategies.1 Managers in Internet compa-
nies confronted a similar dilemma just after their
IPOs. They had recently achieved enough mar-
ket success to sell public equity and now could
invest—or reinvest—in growth. Would doing so
position them for further success?
In step two, we examined factors that influ-
enced firms’ long-term returns, defined as the ratio
of a company’s equity and debt market value to
the total amount of capital it had raised histori-
cally. Market values were measured as of year-end
2001–20 months after the Internet stock bubble
burst. Post-bubble valuations were deemed to more
accurately reflect a firm’s long-term performance
potential. The vantage point assumed in step two
was that of a prospective investor trying to predict
ex post returns, based strictly on information avail-
able, ex ante. Again, the company’s IPO served as
the common reference point for this prediction.
In step two models testing Hypothesis 4, we
measured a firm’s commitment to accelerated
growth using the residual of the step one equation
estimating IPO-year marketing spending. A pos-
itive residual indicates that a company invested
more heavily in customer acquisition efforts than
would be predicted, after controlling for firm and
market characteristics. Using this approach, we
explored whether the sample companies tended to
invest in growth, ex ante, at levels that maximized
long-term returns, observed ex post.
Estimation of marketing
IPO-year marketing spending (‘MKT’) was esti-
mated as part of a system of simultaneous equa-
tions due to endogeneity discussed below, using
the following variables. Sample statistics and a
correlation matrix are provided in Tables 2 and 3,
respectively.
1
An alternative approach, calibrating variables using a common
calendar period rather than IPO-year as a reference point, was
tested. A step two model that estimated year-end 2001 return
on invested capital using 1999 data for independent variables
(1999 was the only year during which all sample firms were
active) yielded a poorer fit than an otherwise identical model that
used IPO-year data. Furthermore, in contrast to results reported
below for models using IPO-year data, in the model employing
1999 data, the proxy for accelerated growth and its interactions
with other predictors were not statistically significant. This is not
surprising: Internet categories evolved at very different rates, so
analysis that relies on a common calendar period as a reference
point confronts considerable heterogeneity in firms’ strategic
decisions.
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DOI: 10.1002/smj
1190 T. R. Eisenmann

Control variables Backing by top venture capitalists (VCs). The

Time elapsed since IPO. The variable ‘TIME’
controls for the possibility that marketing spending
escalated as the Internet bubble progressed, in
response to investors rewarding revenue rather
than profit growth. TIME is measured as years
elapsed between a company’s IPO date and year-
end 2001. 85 percent of the firms completed their
IPOs during the 24-month period commencing in
August 1998; the balance went public before then.
B2B focus. The indicator ‘B2B’ (for ‘business-to-
business’) is set to one for the 21 percent of sample
companies that predominantly served enterprise
customers. Brand building was expected to be a
lower priority for these companies, compared to
firms focused on consumer markets.
variable ‘VC’ controls for two factors that might
influence marketing spending. First, due to their
industry experience, elite VCs may be better able
than other investors to identify high-potential firms
that can profitably spend more on marketing. Sec-
ond, VCs may have incentives to encourage rapid
growth because they often realize attractive returns
by selling equity upon the expiration of IPO ‘lock-
up’ provisions. An indicator is set to one for the
36 percent of sample companies backed by one of
the 25 largest Internet-focused VC firms, based on
Venture Economics data for 1990–99 total capi-
tal deployed in the Internet sector. Backing was
assumed if a VC firm owned at least 5 percent of
a company’s pre-IPO equity and if one of the VC
firm’s partners served on the company’s board of
directors.

Table 2. Variables and descriptive statistics

Measure Variable Sample Sample

name mean (S.D.)a median

Long-term return on invested capital (year-end ROI 1.56 0.33

2001 market value/total capital raised) (3.45)
IPO-year marketing ($ million) MKT 28.16 22.30
(24.91)
Elapsed time since IPO (in years from TIME 2.60 2.34
Dec. 31, 2001) (0.94)
IPO-year sales ($ million) SALES 45.26 21.68
(91.07)
IPO-year earnings before interest and taxes EBIT −54.75 −31.20
($ million) (105.30)
Indicator for backing by one of the 25 largest VC 0.36 0.00
venture capital firms, based on 1990–99 (N/M)
Internet sector capital deployed
Indicator for business-to-business customer focus B2B 0.21 0.00
(N/M)
IPO-year relative market share within competitive RMS 40.10 1.86
set (firm’s share divided by largest rival’s share) (48.44)
Indicator for first mover in competitive set FIRST 0.50 1.00
(N/M)
Winner-take-all structural attributes (composite of WTA 5.23 5.00
variables measuring network effects, scale (1.90)
economies, and switching costs)
Cash balance two quarters after IPO ($ million) CASH 84.19 52.20
(91.11)
Residual of equation estimating cash balance RESCASH 0.00 0.02
(0.90)
Residual of equation estimating marketing RESMKT 0.00 0.08
(0.70)

a
Represents mean and S.D. before transformations and standardization, except for RESMKT and RESCASH, which are residuals
from equations estimating the standardized logarithms of marketing and cash balances, respectively.
N/M denotes that the standard deviation for an indicator variable is not meaningful.

Copyright  2006 John Wiley & Sons, Ltd. Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Table 3. Correlation matrix

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

1. ROI 1.00
2. MKT 0.00 1.00
3. TIME 0.22 −.0 1.00
4. SALES 0.23 0.67 0.02 1.00

Copyright  2006 John Wiley & Sons, Ltd.

5. EBIT 0.21 −0.60 0.47 −0.31 1.00
6. VC 0.01 0.24 0.01 0.25 −0.23 1.00
7. B2B 0.17 −0.11 0.00 −0.07 0.10 −0.03 1.00
8. RMS 0.15 −0.21 0.17 −0.13 0.13 0.13 0.17 1.00
9. FIRST 0.14 0.00 0.19 0.04 0.07 0.10 0.17 0.58 1.00
10. WTA 0.35 −0.02 0.02 0.11 0.07 0.06 0.23 −0.13 −0.11 1.00
11. FIRST * WTA 0.09 0.03 0.02 0.01 −0.03 −0.03 0.12 0.07 0.00 0.05 1.00
12. CASH 0.03 0.39 −0.13 0.28 −0.34 0.27 0.10 −0.11 −0.09 0.04 0.06 1.00
13. RESCASH −0.03 −0.03 0.00 −0.22 −0.08 0.00 0.00 −0.04 −0.09 0.00 0.11 0.80 1.00
14. RESMKT 0.07 0.70 0.00 0.40 −0.27 0.00 0.00 0.02 0.04 0.00 −0.05 −0.21 −0.44 1.00
15. RESMKT2 −0.04 −0.32 0.02 −0.08 −0.01 −0.08 −0.02 0.06 −0.02 −0.12 0.05 0.03 0.11 −0.43 1.00
16. FIRST * −0.20 0.08 −0.07 0.05 −0.05 0.13 0.03 −0.02 0.00 −0.05 0.01 0.14 0.08 −0.04 −0.10 1.00
RESMKT
17. FIRST * 0.14 −0.22 0.24 −0.09 0.10 −0.06 0.12 0.34 0.50 −0.01 −0.10 −0.15 −0.09 −0.07 0.14 −0.37 1.00
RESMKT2
18. WTA * 0.06 −0.23 0.21 0.00 −0.03 −0.06 −0.01 −0.02 −0.05 0.02 0.13 −0.06 −0.02 −0.21 0.49 −0.03 0.09 1.00
RESMKT
19. WTA * 0.24 0.26 −0.10 0.14 −0.01 0.02 0.17 −0.01 −0.01 0.43 0.06 −0.07 −0.16 0.37 −0.62 0.08 −0.27 −0.46 1.00
RESMKT2
20. FIRST * WTA * 0.23 −0.11 0.16 −0.04 0.03 −0.02 0.03 0.04 0.00 0.13 0.02 −0.03 0.02 −0.03 0.13 −0.21 0.43 0.16 0.00 1.00
RESMKT
21. FIRST * WTA * −0.13 0.17 −0.12 0.04 −0.13 0.08 0.13 −0.13 −0.09 0.07 0.43 0.08 0.03 0.08 −0.30 0.37 −0.58 0.01 0.36 −0.46 1.00
RESMKT2
22. RESCASH * −0.04 0.05 0.14 −0.07 0.12 −0.04 −0.02 −0.09 0.07 −0.02 −0.02 −0.07 −0.03 0.17 −0.62 −0.14 0.14 −0.32 0.25 0.04 0.01 1.00
RESMKT
23. RESCASH * −0.08 −0.33 0.01 −0.24 0.04 0.05 0.03 0.00 −0.07 −0.14 0.03 0.43 0.56 −0.64 0.53 0.13 −0.02 0.28 −0.62 0.02 −0.08 −0.42
RESMKT2

Represents correlation of variables after transformations and standardization.

p < 0.10 for correlations >0.155 and < − 0.155
Internet Companies’ Growth Strategies

Strat. Mgmt. J., 27: 1183–1204 (2006)

1191

DOI: 10.1002/smj
1192 T. R. Eisenmann
Relative market share. The variable ‘RMS’ mea-
sures a sample company’s IPO-year relative mar-
ket share within its competitive set (as defined
below), that is, the company’s market share divided
by the share of its largest rival. For the 27 per-
cent of sample firms that completed the only IPO
within a competitive set, RMS is arbitrarily set
at a maximum value of 100. A negative relation-
ship between RMS and marketing expenditure was
expected. Companies with dominant positions are
not likely to realize a pay-off from heavy market-
ing investments, whereas firms with lower relative
market shares might need to invest aggressively to
gain scale and thereby ensure survival. This sur-
vival imperative could be especially acute in WTA
markets. To test this possibility, the model estimat-
ing marketing expenditures includes the interaction
of RMS and WTA, the variable (described below)
measuring WTA structural attributes.
IPO-year sales. A positive endogenous relation-
ship was expected between IPO-year sales
(‘SALES’) and marketing because larger com-
panies typically spend more on marketing, and,
conversely, incremental marketing expenditures
should boost sales. Consequently, sales and mar-
keting were estimated simultaneously. In addi-
tion to marketing, the equation estimating SALES
included three controls. TIME controls for the pos-
sibility that public investors gradually relaxed the
threshold sales needed for an IPO. VC controls
for intrinsic differences in quality that might yield
stronger sales. A system of indicators (collectively,
‘MODEL’) for generic business models controls
for differences in cost structure that might impact
the threshold sales required to satisfy public equity
investors’ expectations.
Cash balances. Post-IPO cash balances (‘CASH’)
were included as a control in the model estimating
IPO-year marketing for two reasons. First, CASH
controls for differences in company quality. Firms
perceived to have stronger growth prospects might
be able to raise more capital. Second, CASH con-
trols for the possibility that some firms faced fund-
ing constraints. ‘Cash-poor’ companies might have
been motivated to invest in marketing, but unable
to raise the capital required to do so (Spence, 1979;
Chevalier, 1995; Zingales, 1998).
CASH measures a firm’s cash and marketable
securities at the end of the second quarter after
Copyright  2006 John Wiley & Sons, Ltd.
its IPO. Facing strong demand for Internet equi-
ties, some companies restricted the number of IPO
shares they offered and deliberately underpriced
their IPOs, hoping for strong post-IPO stock price
appreciation and attendant publicity (Schultz and
Zaman, 2001). These firms typically relied on pri-
mary equity offerings completed several months
after their IPOs to provide additional capital for
expansion. Consequently, a company’s cash bal-
ance a few months after its IPO is used as a proxy
for the company’s ability to raise capital.
Due to an endogenous relationship with sales,
cash balances were estimated simultaneously. Cash
balances were expected to increase with sales due
to working capital requirements. Conversely, IPO
investors might view strong early sales as a sig-
nal of long-term potential and commit more capi-
tal. In addition to SALES, the equation estimating
CASH included several controls. TIME controls
for the possibility that public investors bid up Inter-
net firms’ valuations as the bubble progressed.
VC controls for intrinsic differences in quality
that might yield stronger valuations. B2B con-
trols for the possibility that business-to-business
focused Internet companies were able to com-
mand high valuations at points in time, as spec-
ulators searched for the ‘next new thing.’ Finally,
indicators for generic business models control for
investor fads, and reflect intrinsic differences in the
amount of funding required for working capital and
to support upfront infrastructure investments.
Predictors testing hypotheses
Predictors in the equation estimating IPO-year
marketing included variables measuring first-mov-
er status, participation in WTA markets, and first-
mover status in WTA markets. These predictors
test Hypotheses 1, 2, and 3, respectively.
First-mover status. As noted by Tellis and Golder
(2002: 20), if market boundaries are tightly drawn,
most companies can be classified as pioneers. Con-
scious of this, competitive sets were defined to
include companies that sold products or services
likely to be viewed as close substitutes. For exam-
ple, 34 companies that employed the online retail-
ing business model were divided into 23 compet-
itive sets, including retailers of books (e.g., Ama-
zon.com), garden supplies (e.g., Garden.com), and
sporting goods (e.g., FogDog). Incorporation dates
were used to determine market entry rank within
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies
competitive sets, except when a company diver-
sified into its set from another line of business.
In such cases, market entry order was based on
website launch dates for all competitors in the set.
An indicator, ‘FIRST,’ was set to one for the 50
percent of sample companies categorized as first
movers.
Competitive sets encompass all companies that
ever satisfied the sample selection criteria des-
cribed above, including firms that subsequently
diversified or merged. Consistent with these crite-
ria, sets exclude companies that never completed
an IPO, as well as units of publicly traded cor-
porations omitted either due to their parent com-
pany’s diversification or its concentration of rev-
enue in offline channels. These exclusions raise
the possibility that some sample companies cat-
egorized as first movers may actually have been
early movers, rather than true category pioneers.
It was difficult to resolve ambiguity about the first-
mover status of small private companies. A cate-
gory’s early history was often poorly documented,
because published accounts of competitors typi-
cally did not appear until the category had reached
a threshold scale. By contrast, it was possible
to determine when public corporations launched
online operations. Category-by-category analysis
revealed only one case—online banking—where
an offline incumbent launched an online unit in
advance of a sample company categorized as a first
mover.
Winner-take-all structural attributes. A consis-
tent approach was used to gauge the strength
of three structural attributes that may engender
or reinforce WTA competitive dynamics: network
effects, fixed cost-based scale economies, and
switching costs. Categorical variables measured
each attribute on a high/medium/low scale, based
on an assessment of each company’s generic busi-
ness model. The logic behind the assessments was
developed over the course of a multi-year research
project on Internet companies’ growth strategies,
and in that context was reviewed by over two
dozen scholars and managers with relevant exper-
tise.
Network effects. Network effects pose measure-
ment challenges, because they are a consequence
of utility functions that ascribe value to customers’
Copyright  2006 John Wiley & Sons, Ltd.
1193
inherently unobservable expectations about net-
work size (Katz and Shapiro, 1986). In some mar-
kets, proxies for such expectations may be avail-
able (e.g., Saloner and Shepard, 1995), or hedonic
regression may be used to estimate the strength of
network effects (e.g., Gandal, 1994; Brynjolfsson
and Kemerer, 1996). However, these approaches
are better suited for studies of single product mar-
kets than for cross-sectional analysis.
A categorical variable (‘NETWORK’) reflects
an assessment as to whether network effects were
weak, moderate, or strong for a sample company’s
generic business model (NETWORK = 1, 2, or 3,
respectively). Two types of network effect were
identified (Katz and Shapiro, 1985; Economides,
1996): (1) direct effects, through which a growing
network becomes increasingly attractive to users
because it allows point-to-point exchanges with
additional parties; and (2) indirect effects, through
which a growing user base elicits the production
of a greater variety of complementary goods, or
through which growth in the number of buyers
and sellers participating in a mediated marketplace
improves the odds of finding suitable trading part-
ners. Each generic business model was analyzed to
determine whether a given type of network effect
was critical to success, of secondary importance,
or insignificant. Based on this analysis, a scoring
algorithm was used to rate the strength of network
effects.
Two of the generic business models—networked
utilities and market makers—were deemed to be
subject to strong network effects; these business
models were employed by 13 percent of sam-
ple companies. Two models—portals and bro-
kers—were determined to be subject to moder-
ate network effects. Network effects were rated
weak for the remaining models: ISPs, ASPs, con-
tent providers, and retailers. These models were
employed by 63 percent of the sample companies.
Supply-side scale economies. Learning effects
tend to be strong for high value-added, continu-
ous process manufacturers, but their impact in the
service sector—which encompasses Internet com-
panies—is less well understood (Day and Mont-
gomery, 1983). Consequently, this research does
not appraise dynamic scale economies. Measur-
ing static scale economies for Internet compa-
nies posed two challenges. First, given uncer-
tainty about the long-term revenue potential of
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
1194 T. R. Eisenmann
Internet markets, it was not possible to calcu-
late minimum efficient scale relative to mature
market size—a traditional measure of static scale
economies in industrial organization studies. Sec-
ond, the expense categories reported by Internet
companies do not always correspond to fixed and
variable cost distinctions. For example, ‘website
development’ is usually a fixed cost, but for B2B
sites this category often includes system integra-
tion costs that vary directly with the number of
new users.
Average variable contribution margins (VCMs,
i.e., revenue, less variable costs unrelated to cus-
tomer acquisition efforts, divided by revenue) were
used to measure static scale economies. Through
field interviews, managers provided information
on VCMs. A categorical variable (‘SCALE’) sep-
arated the generic business models into three
groups. The first (SCALE = 1, corresponding to
weak scale economies) had low VCMs (below
40%) and encompassed 38 percent of the sam-
ple companies, included ISPs, ASPs, and retail-
ers. Brokers, with moderate VCMs (40–80%),
comprised the second group (SCALE = 2). The
remaining business models, employed by 44 per-
cent of the sample companies, had high VCMs
(80%+) and were categorized as having strong
static scale economies (SCALE = 3).
Switching costs. A precise measure of customer
switching costs would require account-level analy-
sis of transaction costs, along with estimates of the
inherently unobservable disutility experienced by
customers when they change vendors (Shy, 2002).
Lacking this data, qualitative assessments were
based on seven types of switching costs (Klem-
perer, 1995). Each generic business model was
analyzed to determine whether a given type of
switching cost was critical to customer retention,
of secondary importance, or insignificant. Based
on this analysis, a scoring algorithm was used to
rate the overall strength of switching costs for
each model. Switching costs were deemed to be
low (‘SWITCH’ = 1) for content providers and
retailers, representing 55 percent of sample obser-
vations; moderate (SWITCH = 2) for portals and
brokers; and high (SWITCH = 3) for all other
models, which encompassed 21 percent of the sam-
ple companies.
Composite measure. To measure the collective
strength of winner-take-all structural attributes, a
Copyright  2006 John Wiley & Sons, Ltd.
composite, ‘WTA,’ sums the categorical variables
that reflect network effects, static scale economies,
and switching costs. Due to collinearity between
these variables (r = 0.44 for NETWORK and
SCALE; r = 0.74 for NETWORK and SWITCH;
r = 0.14 for SCALE and SWITCH), it was diffi-
cult to test their separate impact. This collinearity
was expected, since scholars cite network effects,
supply-side scale economies, and switching costs
as defining characteristics of networked industries
(e.g., Arthur, 1996; Shapiro and Varian, 1999; Shy,
2001).
As anticipated, the composite variable WTA was
a positive, significant predictor (p < 0.05) of con-
centration within competitive sets, based on analy-
sis of traffic data for all websites tracked by Media
Metrix—not just the sample companies—within
each of 40 competitive sets. The websites’ traffic
shares (based on total minutes of use in December
2001) were employed to calculate each compet-
itive set’s Herfindahl–Hirschmann Index (HHI),
which equals the sum of competitors’ squared mar-
ket shares. WTA values were assigned to com-
petitive sets based on generic business models,
then regressed against category HHIs. As WTA
is increased from −1 to +1 standard deviations
of its sample mean, predicted HHI increases from
1,575 to 2,688. This analysis confirms that many
Internet markets have been subject to WTA com-
petitive dynamics (Hand, 2001; Noe and Parker,
2000). Across the 40 competitive sets, the average
HHI was 2,131. Markets with HHI scores in excess
of 1,800 are considered highly concentrated, based
on Department of Justice guidelines.
Model form
Marketing, sales, and cash balances were estimated
simultaneously, using three-stage least squares
regression. Prior to estimation, variables were stan-
dardized to reduce collinearity between the inter-
action terms and their components. Logarithmic
transformations were employed for all continuous
variables because a log-log specification facilitates
the parsimonious estimation of a mix of different
nonlinear relationships. In the marketing equation,
for example, a concave relationship was antici-
pated with SALES, whereas a convex relationship
with WTA was seen as possible.
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies
Estimation of long-term returns
The dependent variable measures long-term return
on invested capital (‘ROI’). The variable’s numer-
ator sums the market value of a company’s equity
and the book value of its debt (assumed to approx-
imate the debt’s market value) at year-end 2001.
The denominator equals the total amount of equity
and debt capital raised (net of any equity repur-
chases or debt repayments) over a period that
includes the company’s last two full fiscal years as
a private company plus all periods during which it
had publicly traded equity.
Eighty-two sample companies (70% of the sam-
ple) were going concerns as of year-end 2001. For
19 sample companies (16%) that were bankrupt or
had been delisted prior to the end of 2001, equity
and debt values were assumed to be zero. The
remaining 16 sample companies (14%) announced
they were being acquired and completed that trans-
action during 2001. For these companies, market
value was assumed to equal the total proceeds
received by investors.
The dependent variable’s distribution is skewed:
the sample mean ROI is 156 percent, but the
median is only 33 percent. ROI exceeded 100
percent for only 32 sample companies (27% of
the sample). The sample mean is boosted by the
strong performance of a few firms, in particular,
eBay and Travelocity, which both had year-end
2001 valuations about 20 times greater than the
total amount of capital they had raised. Omitting
these two firms from the sample (and likewise,
firms with the five highest values of ROI) had no
impact on the signs or statistical significance of the
parameter estimates reported below.
ROI does not reflect returns actually realized by
investors, unless they purchased a pro-rata share
of all a firm’s equity and debt, then followed
a ‘buy-and-hold’ strategy through year-end 2001.
Depending on when they bought and whether and
when they sold securities, investors’ actual returns
could differ substantially from ROI. Hence, ROI
should be viewed as a proxy for the performance
potential of a firm’s asset base—akin to Tobin’s
Q, which was not employed owing to the pre-
ponderance of intangible assets held by Internet
companies.2
2
Tobin’s Q statistic, which equals the market value of a firm’s
capital divided by the replacement value of assets, is frequently
used as a performance measure in the strategic management
literature. However, Tobin’s Q is not well suited for studying
Copyright  2006 John Wiley & Sons, Ltd.
1195
ROI does not reflect differences in the timing of
capital infusions. As a sensitivity analysis, equity
and debt proceeds were inflated to year-end 2001
by 15 percent and 10 percent annually, respec-
tively. Recalculating ROI using this time value-
adjusted denominator reduces the sample mean
from 156 percent to 122 percent, but has no impact
on the sign or significance of parameter estimates
reported below.
Control variables
The equation estimating ROI includes several vari-
ables that control for firm and market attributes that
could influence long-term returns. TIME reflects
the possibility that investors relaxed standards for
an IPO as the Internet bubble inflated, boosting
the odds of failure for younger companies. Alter-
natively, the ‘grim reaper’ might have harvested
a greater share of older firms with flawed busi-
ness models. SALES was expected to be a pos-
itive predictor of ROI, because a company with
greater sales was assumed to have more fully val-
idated its business model. IPO-year profit before
interest and taxes (‘EBIT’) was expected to be
a positive predictor of ROI, as was RMS. VC
controls for intrinsic differences in firm qual-
ity that might yield stronger long-term perfor-
mance. Finally, ‘RESCASH’ is the residual of
the step one equation estimating cash balances.
RESCASH controls for: (1) intrinsic differences
in company quality that may influence long-term
returns; (2) the possibility that extra cash provided
a cushion against product and capital market turbu-
lence, boosting survival odds; and (3) the possibil-
ity that funding constraints prevented ‘cash-poor’
companies from investing at value maximizing
levels.
Predictors testing hypotheses
In addition to these controls, the model esti-
mating long-term returns includes three predic-
tors described above, reflecting first-mover sta-
tus (FIRST), winner-take-all structural attributes
(WTA), and first-mover status in WTA markets
firms that fail to capitalize heavy investments in intangible assets
(Amir and Lev, 1996). Most Internet companies treat customer
acquisition and website development costs as current period
expenses, even though these investments typically yield returns
over several years. Substituting Tobin’s Q for ROI in the step
two models yields a somewhat poorer fit and regression results
(not reported here) that are broadly similar to those reported
below.
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
1196 T. R. Eisenmann
(FIRST ∗ WTA). Model extensions examine the
impact of accelerated growth strategies on long-
term returns. A company’s commitment to accel-
erated growth was measured as the residual from
the step one equation estimating IPO-year mar-
keting spending. An inverted ‘U’ relationship was
expected between ROI and this residual (‘RES-
MKT’). The square of RESMKT was included to
allow the estimation of such a relationship. The
fully specified model explores whether the rela-
tionship between ex ante commitment to acceler-
ated growth and ex post returns was moderated by
first-mover status, participation in WTA markets,
and the cash balance residual. To test a given vari-
able’s moderating effects, interaction terms were
included that multiply the variable by RESMKT
and RESMKT.2
Model form
Except as noted, variables were standardized and
transformed as described above for the estimation
of IPO-year marketing. EBIT was transformed as
a cube root to avoid calculating logarithms of
negative numbers. For the same reason, a constant
equal to 0.001—the lowest positive value of ROI
observed (Afifi and Clark, 1990: 53)—was added
to ROI before transformation. Tobit estimation was
employed because the dependent variable, prior
to transformation, is naturally censored at zero:
market value cannot be negative.
RESULTS
Estimation of marketing
Regression results for step one models that simul-
taneously estimate marketing, sales, and cash bal-
ances are reported in Table 4. The marketing
model fit the data reasonably well (χ 2 p = 0.000;
pseudo R 2 = 0.53). The fit also was solid for the
sales model (χ 2 p = 0.000, pseudo R 2 = 0.58), but
weaker for the cash balance model (χ 2 p = 0.010;
pseudo R 2 = 0.17). Parameter estimates in the
sales and cash balance models all had signs con-
sistent with predictions, although not all variables
were statistically significant.
In the marketing model, the control variables
measuring elapsed time since a company’s IPO
(TIME), B2B focus (B2B), and relative market
share (RMS) were significant, negative predic-
tors, as predicted. IPO-year sales (SALES), top
Copyright  2006 John Wiley & Sons, Ltd.
VC backing (VC), and cash balance (CASH) had
positive signs, as expected, but were not statisti-
cally significant.
Supporting Hypothesis 1, first-mover status
(FIRST) was a significant, positive predictor of
marketing spending (p < 0.05). Holding all other
variables constant at their respective sample means,
first movers were predicted to spend $23 million
on IPO-year marketing: 44 percent more than non-
pioneers.
Contrary to the prediction of Hypothesis 2,
participation in a market with WTA structural
attributes did not have a statistically significant
impact on IPO-year marketing spending. To deter-
mine whether the individual WTA structural attri-
butes—that is, network effects, static scale eco-
nomies, and switching costs—had influence that
was masked by inclusion in a composite variable,
each attribute was included in a model (not pre-
sented here) that excluded the other two attributes.
Tested separately, none of the attributes were
statistically significant, nor were their respective
interactions with the first mover variable.
Hypothesis 2 does not distinguish between the
winners, losers, and fringe players in WTA mar-
kets. Hypothesis 3 suggests that first movers in
WTA markets had stronger incentives to invest in
marketing, to exploit their early lead. The parame-
ter estimate for the FIRST ∗ WTA interaction had a
positive sign, as expected, but was not statistically
significant. Likewise, the RMS ∗ WTA interac-
tion had the expected positive sign, but was not
significant.
Estimation of return on invested capital
Table 5 presents results for step two models esti-
mating return on invested capital (ROI). Model 1
omits the marketing residual (RESMKT) and its
related quadratic and interaction terms to explore
the robustness of parameter estimates for the
remaining variables. With respect to control
variables, results for Model 1 were close to those
for counterparts in Model 4, the fully specified
equation. Participation in WTA markets was a sig-
nificant, positive predictor of long-term returns
(p < 0.000). First-mover status (FIRST) and first-
mover status in WTA markets (FIRST ∗ WTA)
were positively related to ROI, but not statistically
significant.
Model 2 incorporates the proxy for commit-
ment to accelerated growth—the residual of the
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies 1197

Table 4. Results for simultaneous estimation of marketing, sales, and cash: three-stage least squares parameter
estimates; N = 117

Dependent variables

Independent variables Marketing Sales Cash

(ln MKT) (ln SALES) (ln CASH)
Constant 0.013 0.000 0.000
(0.063) (0.059) (0.083)
Marketing — 0.613∗∗∗ —
(ln MKT) (0.211)
Sales 0.235 — 0.485
(ln SALES) (0.285) (0.453)
Cash 0.404 — —
(ln CASH) (0.264)
Elapsed time since IPO −0.346∗∗∗ 0.287∗∗∗ −0.155∗
(ln TIME) (0.070) (0.100) (0.088)
Top VC backing 0.058 0.098 0.137
(VC) (0.124) (0.080) (0.139)
B2B focus −0.138∗ — 0.168∗
(B2B) (0.080) (0.095)
Relative market share −0.190∗ — —
(ln RMS) (0.107)
Business model dummies — Partial Partial
(MODEL) significance significance
First mover 0.184∗∗ — —
(FIRST) (0.091)
Winner-take-all attributes −0.031 — —
(ln WTA) (0.073)
First mover * WTA attributes 0.015 — —
(FIRST * ln WTA) (0.082)
Relative market share * WTA attributes 0.085 — —
(ln RMS * ln WTA) (0.074)
p(χ 2 ) 0.000 0.000 0.010
Pseudo R 2 0.53 0.58 0.17

∗ ∗∗ ∗∗∗
p < 0.10; p < 0.05; p < 0.01; standard errors are in parentheses.

equation estimating IPO-year marketing spending
(RESMKT) and its square (RESMKT2 )—but ex-
cludes all interaction terms that incorporate these
variables. Results for Model 2 reveal the expected
inverted ‘U’ relationship between long-term returns
and the growth strategy proxy, but the joint impact
of RESMKT and RESMKT2 was not statistically
significant, based on a χ 2 difference test. This was
not surprising, given the strong impact of the inter-
action terms added in Models 3 and 4.
Model 3 adds all two-way interactions, but
omits three-way interactions to ease interpreta-
tion and to isolate the impact of accelerated
growth strategies for first movers in WTA mar-
kets. Based on χ 2 difference tests, the growth
strategy proxy and all of its two-way interac-
tions with variables measuring first-mover sta-
tus and WTA structural attributes are statistically
significant.
Copyright  2006 John Wiley & Sons, Ltd.
Model 4, which adds three-way interactions
and thus presents the fully specified equation,
fits the data fairly well (χ 2 p = 0.000; pseudo
R 2 = 0.20). Coefficients for controls measuring
time elapsed since the firm’s IPO, IPO-year sales,
profitability, relative market share, and cash bal-
ances all had the expected positive signs, but
only SALES and EBIT were statistically signifi-
cant (p < 0.01 and 0.05, respectively). Contrary
to expectations, the coefficient for the variable
measuring top-tier VC backing had a negative
sign, but this relationship was not statistically
significant.
Due to the inherently high correlation between
interaction and quadratic terms and their respective
components, χ 2 difference tests were employed
to assess the joint effect of each predictor and
all interaction terms derived using the predictor.
Based on these χ 2 difference tests, all of the
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
1198 T. R. Eisenmann

Table 5. Results for tobit estimation of return on invested capital—dependent variable: return on invested capital
(ln ROI); N = 117

Independent variables Model 1 Model 2 Model 3 Model 4

Parameter Parameter Parameter Parameter χ2
estimate estimate estimate estimate difference

Constant −0.071 −0.067 −0.040 0.091 —

(0.093) (0.112) (0.110) (0.111)
Elapsed time since IPO 0.074 0.067 0.018 0.040 0.14
(ln TIME) (0.109) (0.112) (0.114) (0.109)
Sales 0.351∗∗∗ 0.336∗∗∗ 0.356∗∗∗ 0.297∗∗∗ 8.03∗∗∗
(ln SALES) (0.109) (0.114) (0.108) (0.105)
Profit 0.238∗∗ 0.256∗∗ 0.321∗∗∗ 0.291∗∗ 5.99∗∗
(EBIT1/3 ) (0.117) (0.127) (0.124) (0.119)
Top VC backing −0.077 −0.069 −0.002 −0.019 0.04
(VC) (0.100) (0.103) (0.099) (0.095)
Relative market share 0.218∗ 0.213∗ 0.132 0.117 1.06
(RMS) (0.119) (0.121) (0.117) (0.114)
First mover 0.042 0.045 −0.005 0.023 3.33∗∗∗
(FIRST) (0.116) (0.117) (0.123) (0.125)
Winner-take-all attributes 0.378∗∗∗ 0.377∗∗∗ 0.158 0.050 5.25∗∗∗
(ln WTA) (0.097) (0.097) (0.111) (0.113)
First mover * WTA attributes 0.049 0.050 0.024 0.215∗∗ 4.23∗∗∗
(FIRST * ln WTA) (0.096) (0.096) (0.093) (0.111)
Cash residual 0.068 0.092 0.064 0.041 3.20∗∗
(RESCASH) (0.098) (0.111) (0.123) (0.118)
Marketing residual — 0.135 0.135 0.198 2.74∗∗∗
(RESMKT) (0.148) (0.148) (0.151)
Marketing residual2 — −0.041 −0.041 −0.276∗∗ 4.17∗∗∗
(RESMKT2 ) (0.092) (0.092) (0.111)
First mover * marketing residual — — −0.301∗∗∗ −0.357∗∗∗ 6.45∗∗∗
(FIRST * RESMKT) (0.106) (0.113)
First mover * marketing residual2 — — 0.119∗ 0.152∗ 2.75∗
(FIRST * RESMKT2 ) (0.071) (0.091)
WTA attributes * marketing residual — — 0.181 0.124 7.49∗∗∗
(ln WTA * RESMKT) (0.124) (0.136)
WTA attributes * marketing residual2 — — 0.249∗∗∗ 0.563∗∗∗ 14.32∗∗∗
(ln WTA * RESMKT2 ) (0.085) (0.149)
Cash Residual * Marketing residual — — −0.079 −0.169 3.77∗∗
(RESCASH * RESMKT) (0.125) (0.124)
Cash residual * marketing residual2 — — 0.144∗ 0.182∗∗ 4.61∗∗
(RESCASH * RESMKT2 ) (0.079) (0.085)
First mover * WTA attributes * marketing — — 0.211 6.11∗∗∗
residual (0.132)
(FIRST * ln WTA * RESMKT)
First mover * WTA attributes * marketing — — −0.419∗∗∗ 9.98∗∗∗
residual2 (0.133)
(FIRST * ln WTA * RESMKT2 )
p(χ 2 ) 0.000 0.000 0.000 0.000
Pseudo R 2 0.101 0.102 0.154 0.195

∗
p < 0.10; ∗∗ p < 0.05; ∗∗∗ p < 0.01; standard errors for parameter estimates are in parentheses.
χ 2 difference test measures joint impact of variable plus any interaction terms that include the variable as a component.

interaction terms and their associated main effects
were statistically significant in Model 4.
Hypothesis 4 predicts that firms will tend to
invest in marketing, ex ante, at levels that max-
imize long-term returns, observed ex post. In
support of Hypothesis 4, Figure 1(a) suggests
Copyright  2006 John Wiley & Sons, Ltd.
that most sample companies spent on IPO-year
marketing at or close to levels that maximized
long-term ROI. Holding all other variables con-
stant at their respective sample means, we see that
the relationship between predicted ROI and the
marketing residual has the expected inverted ‘U’
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies 1199

shape. The curve peaks at +0.33 s.d. of the sample
mean for RESMKT, which implies that firms were
somewhat more likely to underinvest in IPO-year
marketing than overinvest, relative to value max-
imizing levels observed ex post. Specifically, the
typical firm (RESMKT = 0) earned an estimated
ROI of 24 percent, compared to the peak ROI of 26
percent. Predicted ROI equals at least two-thirds
of the peak ROI for 60 percent of sample com-
panies—those with marketing residuals that fall
between −0.4 and +1.1 s.d. of the sample mean
residual.
Interactions in Model 4 test whether the relation-
ship between ROI and the growth strategy proxy
was moderated by first-mover status, participation
in WTA markets, and cash balances. Figure 1(b)
indicates that both first movers and non-pioneers
invested in marketing, ex ante, at levels reasonably
close to those that would have maximized long-
term returns, observed ex post. Predicted ROI for
first movers and non-pioneers reaches its peak
when RESMKT equals −0.6 s.d. and +0.6 s.d.
of its sample mean, respectively. Recall that first
movers, on average, spent 44 percent more on IPO-
year marketing than non-pioneers. It appears that
these upfront investments were close to optimal for
the typical first mover. Interestingly, the curve for
non-pioneers peaks at a higher value of ROI than
the curve for first movers (37% vs. 29%). This
statistically significant difference implies that late-
mover advantages were greater than first-mover
advantages in many Internet markets.

30% 40%

35%
25%
30%
Predicted ROIC
Predicted ROIC

20%
25%

15% 20%

15%
10%
10%
5% 5%

0%
0% -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5
-2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5
(b) Marketing Residual (s.d.)
(a) Marketing Residual (s.d.)
First Movers Non-Pioneers

200% 200%
180% 180%
160% 160%
Predicted ROIC

140% 140%
Predicted ROIC

120% 120%
100% 100%
80% 80%
60% 60%
40% 40%
20% 20%
0% 0%
-2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5
(c) Marketing Residual (s.d.) (d) Marketing Residual (s.d.)
WTA +1 s.d. WTA -1 s.d. Cash Residual +1 s.d. Cash Residual -1 s.d.

Figure 1. Impact on predicted ROI of departures from predicted marketing spending. (a) All sample firms. (b) First
movers and non-pioneers. (c) Firms with high vs. low WTA structural attributes. (d) Firms with high vs. low cash
balances. Note: All other variables held constant at their respective sample means.
Copyright  2006 John Wiley & Sons, Ltd. Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
1200 T. R. Eisenmann
Figure 1(c) presents curves relating predicted
ROI to the growth strategy proxy for firms in
markets with strong and weak WTA structural
attributes (WTA = +1 s.d. and −1 s.d. of its sam-
ple mean, respectively). For all values of the proxy,
predicted long-term returns are higher for com-
panies in WTA markets than for firms not par-
ticipating in such markets. In WTA markets, the
curve slopes sharply upward for positive values
of RESMKT, indicating a propensity to under-
invest in IPO-year marketing, relative to value-
maximizing levels observed ex post. The convex
shape suggests that investments to amass scale
yielded increasing returns in WTA markets. By
contrast, the curve predicting ROI in markets with
weak WTA attributes peaks when the marketing
residual equals zero. This suggests that these firms,
on average, invested in early growth at levels that
maximized long-term returns.
Interactions also test the impact on predicted
ROI of early growth investments by first movers
in WTA markets. After allowing for the separate
effects of FIRST and WTA (described above), the
joint effect of first-mover status in WTA mar-
kets had no incremental impact on the propensity
to over- or underinvest in customer acquisition
efforts, ex ante, relative to value-maximizing lev-
els, observed ex post. Except at extreme levels
of marketing spending (RESMKT > +1.1 s.d. or
< −0.5 s.d.), the joint effect of first-mover sta-
tus in WTA markets boosts predicted ROI, above
and beyond the separate main effects of FIRST
and WTA (χ 2 difference test p < 0.01). This cor-
roborates Lieberman’s (2002) finding that Internet
sector first movers were more likely to achieve
superior valuations when their business models
leveraged network effects.
Finally, Figure 1(d) shows that low cash bal-
ances had no impact on the propensity to over-
or underinvest in customer acquisition efforts, ex
ante, relative to value-maximizing levels, observed
ex post. With RESCASH = −1 s.d. of its sample
mean, predicted ROI peaks when RESMKT = 0.
In other words, there was no evidence that funding
constraints caused companies with low cash bal-
ances to forfeit profitable marketing opportunities.
By contrast, firms with high cash balances (rel-
ative to the step one model’s predicted levels)
exhibited a strong propensity to overspend on IPO-
year marketing. With RESCASH = +1 s.d. of its
sample mean, predicted ROI declines steadily as
RESMKT is increased from −2 s.d. to +2 s.d.
Copyright  2006 John Wiley & Sons, Ltd.
These statistically significant results (χ 2 test p =
0.03) lend support to conventional wisdom about
cash-rich Internet companies: shortly after their
IPOs, many appear to have been ‘throwing good
money after bad’.
DISCUSSION
Based on cross-sectional econometric analysis
using a sample of publicly traded Internet com-
panies, this study explores factors that determined
the intensity of firms’ investments in early growth,
and examines the long-term performance con-
sequences of such investments. With respect to
factors that encouraged the pursuit of acceler-
ated growth strategies, results indicate that cat-
egory pioneers spent significantly more on IPO-
year marketing than late movers. Contrary to
expectations, companies in markets that exhibited
WTA structural attributes—strong network effects,
static scale economies, and customer switching
costs—did not spend more heavily on IPO-year
marketing than firms in markets that lacked such
attributes. Likewise, contrary to expectations, first
movers in WTA markets did not spend signifi-
cantly more on their customer acquisition efforts.
As expected, an inverted ‘U’ relationship was
observed between long-term returns on invested
capital and the proxy for a firm’s level of com-
mitment to early growth. Controlling for other
characteristics, most sample companies invested in
IPO-year marketing at or close to levels that would
have maximized long-term returns, observed ex
post. Consistent with this result, the typical first
mover invested, ex ante, close to optimal lev-
els. However, firms in WTA markets exhibited a
propensity to underinvest in IPO-year customer
acquisition efforts, relative to value-maximizing
levels observed ex post.
These findings challenge conventional wisdom,
which holds that Internet companies destroyed
value by overspending on marketing to meet spec-
ulators’ revenue growth expectations. The results
reported above indicate that if the typical sample
company had decreased its IPO-year marketing
spending, it would have further reduced its already
poor long-term returns. When pay-offs depend on
competitors’ actions, unilateral moves to deesca-
late may not succeed unless rivals follow suit.
Internet companies seem to have been caught in
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
 Internet Companies’ Growth Strategies
a prisoner’s dilemma, unable to coordinate their
spending and thereby improve performance.
The finding that typical firms in WTA mar-
kets underinvested in early growth is somewhat
surprising. Two explanations for this result seem
plausible. First, it is possible that managers in
WTA markets systematically underestimated the
strength of increasing returns. Given the Inter-
net’s newness, we can see why managers might
have made mistakes in estimating the productiv-
ity of marketing investments. However, based on
research cited above, we would have expected
managers to be prone to errors of overconfidence,
rather than excessive conservatism. Second, the
equation estimating marketing may omit variables
that were particularly relevant for firms in WTA
markets. Unobserved attributes could have allowed
some firms in WTA markets to profitably boost
their IPO-year marketing spending, while firms
lacking these attributes appropriately spent less.
For example, the relative effectiveness of cost-
less customer word-of-mouth vs. costly advertising
might vary across markets. Alternatively, compa-
nies might differ in the degree to which they enjoy
‘instant scalability,’ that is, the ability to expand
without straining production or delivery capacity
(Liebowitz and Margolis, 2001: 82).
Generalizability
The generalizability of this study’s findings would
be limited if Internet companies’ growth strategies
were idiosyncratic due to the enormity of the
dot com bubble. However, boom–bust valuation
cycles occur with surprising regularity (Sahlman
and Stevenson, 1985; Kindleberger, 2000), so we
might expect to see similar outcomes in other
industries when speculative excess leads investors
to place undue emphasis on revenue and market
share growth. Furthermore, the results reported
here suggest that irrational exuberance in capital
markets did not lead to managers in typical Internet
companies to overinvest in growth, except in firms
with unusually large cash balances. Consequently,
we believe that the study’s findings may hold in
other new markets in which first-mover advantages
and WTA structural attributes are salient, not just
those subject to market manias.
Copyright  2006 John Wiley & Sons, Ltd.
1201
Suggestions for future research
The models presented above could be enhanced
in several ways. First, the models presume that
long-term performance is determined by early
growth investments, but that the reverse is not
true. However, expectations regarding long-term
performance influence early growth investments.
A proxy for such expectations—equity analysts’
forecasts for sales growth in the year following
a firm’s IPO—was tested, but was not a statisti-
cally significant predictor of marketing spending.
Ideally, a proxy would reflect expected growth
over a longer period, but even 2-year growth fore-
casts were available for only half of the sample
firms. Future research could develop valid mea-
sures of growth expectations and test their impact
on early investments. Such research could shed
additional light on whether Internet companies that
invested heavily in early growth did so rationally,
in response to expectations regarding long-term
opportunities, or to exploit speculative excess in
capital markets.
Second, in the models above, WTA attributes—
network effects, static scale economies, and switch-
ing costs—are measured at the generic business
model level. This approach does not capture firm-
level factors that may strengthen or weaken each
attribute, relative to generic business model norms.
For example, whereas online retailers are cate-
gorized as generically exhibiting weak network
effects and weak static scale economies, Amazon
has engendered network effects through its affiliate
program and used goods marketplace, and exploits
static scale economies by leveraging heavy IT
investments across multiple product lines. Exten-
sions of this research could develop firm-level
measures for WTA structural attributes.
Third, researchers could consider whether the
findings reported here regarding marketing spend-
ing apply for other tactics that companies may use
to accelerate their growth, in particular, aggressive
discounting and mergers. Prior theoretical work
posits conditions under which certain tactics may
be more effective than others. For example, merg-
ers have been viewed as an attractive alternative
to cutthroat price wars (Telser, 1966).
Fourth, future research also could explore when
accelerated growth strategies are likely to manifest
themselves as racing behavior (reflected in strate-
gic interaction between rivals, as in Harris and
Strat. Mgmt. J., 27: 1183–1204 (2006)
DOI: 10.1002/smj
1202 T. R. Eisenmann
Vickers, 1987), as opposed to ‘one-shot’ invest-
ment commitments. The theoretical literature on
racing is devoted mostly to R&D contests (see
Reinganum, 1989, for a summary) and preemptive
capacity expansion, and provides little guidance
on when firms are likely to race to acquire cus-
tomers. A cross-sectional design like this study’s
cannot distinguish between racing behavior and
one-shot commitments. Detecting strategic interac-
tions would require a longitudinal research design
and data for a critical mass of rivals within a com-
petitive set, as in Cockburn and Henderson (1994).
In a context in which racing behavior was dis-
sipating industry rents, it would be interesting to
study the ability and willingness of rivals to jointly
de-escalate. Research suggests that mutually ben-
eficial de-escalation is more likely when compe-
tition involves a small number of rivals with a
history of interaction, an expectation of continued
contact, and extensive shared information about
market opportunities and rivals’ perceived pay-offs
(Dixit and Nalebuff, 1991). For many Internet mar-
kets, these conditions did not apply, which may
explain the prisoner’s dilemma described above.
Finally, the finding that Internet companies in
WTA markets were likely to underinvest, ex ante,
relative to ex post optimal levels, warrants further
study. Researchers should determine whether this
pattern is evident in other settings, and whether
the propensity to pursue accelerated growth strate-
gies in WTA markets is influenced by factors not
measured in this study, for example, the intrinsic
scalability of a company’s business model.
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